Mary Reid works as a financial advisor at Wells Fargo Wealth Management team. Sh

Question

Mary Reid works as a financial advisor at Wells Fargo Wealth Management team. She is a big believer of the capital asset pricing model and often use it for making recommendations to her clients. One of her clients has identified two stocks and wants to discuss some investment opportunity with Mary. Wells Fargo’s research department has developed the information shown in the following exhibit.

Forcast Returns, Standard Deviations, and Betas                       

1. Calculate expected return and alpha for each stock.

2. Identify and justify which stock would be more appropriate for this investor who wants to

            --add this stock to a well-diversified equity portfolio.

            --hold this stock as a single-stock portfolio.

Forcast Return Standard Deviation Beta Stock X 14% 36% 0.8 Stock Y 17 25 1.5 Market Index 14 15 1.0 Risk-Free rate 5

Explanation / Answer

Expected Return of stock x =5% + 0.8*(14% -5%)

=12.2%

Foercast retrurn = 14%

Alpaha =14% 12.2% =1.8%

Expected return of stock =5% +1.5*(14%-5%)

=18.5%

=17%

Alpha = 17% =18.5% -1.5%

Sharpe ratio

Stcok X = 12.2% -5%/36% =.2

Stock Y = 18.5% - 5%/25%

=0.54

As stock y has mopre sharepe ratio its more good stcok for portfolio

Buy as stock x produces alpha it is better as indicvidual stock

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